Buying Versus Leasing a Car
Buying versus leasing a car is something that everyone has to deal with. Neither leasing nor buying has a clear advantage over the other, which makes this a somewhat difficult topic to discuss with clients. Many of the advantages and disadvantages depend upon the clients personal preferences and needs. The question of buying versus leasing a car comes up frequently, so we wanted to share some thoughts on the key decision areas.
Before we get into the topic, this posting is focused more on the individual versus a business purchasing or leasing a car. Many of the same decisions discussed below are still needed for a business, but a business can get tax deductions related to leased and purchased cars. There is more complexity with a business, however, as the IRS has rules as to how much depreciation can be taken each year and for vehicles used by owners and/or employees, there are involved reporting requirements as to the value of this fringe benefit. The value needs to be computed annually, documentation retained by the business to support the business use and the fringe benefit value is includable in an owner and/or employees gross wages, making the value part of taxable income.
Below are the major decision items to think about for an individual, with comments related to each decision item.
- Vehicle ownership – When you purchase a car using a loan, the client has an asset and a liability. Once the loan is paid, they have an asset. Once owned, the client can continue to use the car, sell it outright, or trade it in for a new car. When you lease a car, you must return the car to the lease company at the end of the contract (unless there is an option to buy and you plan to exercise it – most leases have the option to buy provision, with an agreed to price). You don’t own the car and you don’t have an asset left over when all the lease payments are made. If someone wants a “new car” every few years, then this probably isn’t a concern. If the client keeps cars for more than four years, then it’s probably better to buy. Also a car is a depreciating asset and it declines in value over time. If possible, we think what makes the most financial sense is to buy in cash a car with lower miles, since the value is much lower than a new car and there is no interest costs. There are comments below about financing a car.
- Monthly payments – When you buy a car, the monthly payment is based on the purchase price of the car, less any down payment, so principal is the purchase price and payments include interest. When you lease a car, the monthly payment is based on the purchase price of the car, less a residual value or the automobile’s depreciated value. Over the term of the lease, payments equal to the expected depreciation of the car (difference between purchase price and residual value) plus a lease fee. The monthly lease payment is usually lower than the monthly loan payment for a comparable car (assuming there wasn’t a large down payment in the case of a loan). For cash flow planning, if the size of the monthly payments is an issue, or the client wants more car for the dollar, a lease is probably better. Lease payment computations are complicated as well. Loan payments are straight forward to calculate.
- Down payment – When you buy a new car, you typically need a down payment or trade-in. You may have to come up with 10 percent or more of the new car’s value. The down payment can vary depending on the lender and client credit rating. When you lease a car, there’s typically no down payment (usually payments advertised reflect a down payment – read the fine print! We typically do not recommend making a lease down payment as you do not own the vehicle). Lease terms typically require a first lease payment and perhaps a security deposit equal to one or two months of lease. If the client doesn’t have cash for a down payment for a purchase, but needs a car now, then leasing might be best.
- Mileage limitations – When you buy a car, you’re free to drive it as much and as far as you like. When you lease a car, your annual mileage is limited by the terms of the contract. The typical lease limits mileage to 12,000 or 15,000 miles per year. In some cases, you can “buy” more mileage for a lease and this will impact the lease payment/residual value. Conversely, if you know you do not drive say 15,000 miles per year, do not negotiate a lease contract that uses 15,000 miles, negotiate a lower mileage limit, which lowers the lease payment. If you drive the car more than the lease provides, there is a per-mile fee charge for each mile over the contract limit which is an additional cost. Most people have a sense of how many miles they drive each year, so if someone knows the base lease miles are low, they should consider a higher annual mileage amount and compute the lease payment on the higher amount. Alternatively, for people who do not drive a lot of miles, it may make more financial sense to buy, since low mileage cars have a higher value as the years go buy than higher mileage cars.
- Normal wear and tear – When you purchase a car, there are generally no issues regarding wear and tear – it’s your car. When you lease a car, normal wear and tear can become a big issue. The lease company has to resell the car once the lease term expires. Excessive dings, dents, cracks, stains, tears, or unusual wear can result in penalties (i.e. will cost you more money) when you turn the car in. Your lease agreement dictates what will be deemed normal wear and tear. If you’re fairly meticulous about maintaining and cleaning your cars, then this isn’t a problem. If you tend to be rough on your car, then buying might be a better option. Caution – what someone might consider to be normal wear and tear is not what the lease company may decide is normal. Also, there are requirements typically for a certain amount of tire tread left at turn in of the leased car and if the tires are below the minimum, there is an additional cost.
- Trading every few years – If you buy a car and trade it every few years, there are matters to deal with. You must negotiate the value of the trade-in and for many, this is very stressful. Generally, dealers want to sell a new car at as close to MSRP as possible, and use wholesale value for a trade-in. That way, they can make a second profit when they sell your trade-in to someone else at its retail price. You can try and sell your car yourself, which can also be stressful, take time and you will have to negotiate a price with the buyer. If there is an outstanding car loan balance, that needs to be factored into the sales price, as the loan will need to be paid off, leaving dollars for (presumably) a down payment on the client’s next car or additional cash maybe needed on top of the sale price, less loan payoff. In theory, leases are ideal for people who want to switch cars every few years. You lease a car for two to four years. At the end of the lease term, you drop the car off at the lease company, pick out a new car, sign a new lease, and drive away. There’s no haggling over trade-in allowance and no worries about loan payoffs or down payments. That is a big advantage of leasing. See comments earlier about wear, tear, mileage, etc.
- Getting rid of your car early – When you buy a car, you can sell it or trade it at any time you like, of course, subject to any outstanding loan balance. When you lease a car, you may be stuck with it for the term of the lease. There are generally steep penalties for early termination of a lease. You are responsible for all remaining payments on the lease. Consider the likelihood that your cash flow situation could change, or other financial situations may occur – divorce, disability, getting married, birth of a child/children, job change, etc. A change of jobs might affect your automobile needs and the number of miles you drive, for example. In any of these situations, it’s generally easier to trade out of a purchased car than a leased car, especially if the lease is relatively new.
- Cheapest alternative – If you plan to keep a car for only a short time period, a lease should result in less cash being spent. You will only be paying for the use of the car and can walk away from it when the lease expires. If you plan to keep a car for a long period of time, you will usually do better by purchasing it (and even better is purchasing without paying loan interest, unless there is a zero percent loan). The total cost of your lease payments plus the cost of purchasing the car at the end of the lease typically exceeds the cost of a basic car loan. Of course, there are always exceptions to these rules.
- Insurance expense – When you buy a car, you must insure it up to the minimum amounts required by state law (check with your insurance company on this). Your lender may have additional requirements. When you lease a car, you’re usually required to carry more insurance than what the state requires. The additional coverage results in additional insurance premiums. Find out what the coverage requirements are and contact your insurer for quotes. Be sure to include the additional insurance expense in your calculations when comparing a purchase to a lease. Generally speaking, we think carrying higher insurance limits makes good financial sense, regardless of buying versus leasing a car. Depending on the client’s personal financial situation, assets and cash flow, having higher insurance limits, along with higher deductibles can be a solid financial decision.
- Freedom to modify vehicle – One advantage of owning a car is that you can paint it, modify it, or change it as you like. If you want these liberties, you should buy. When you lease a car, you don’t have these liberties. It’s not your car. Provisions in your lease agreement typically prevent you from making any material changes to the vehicle. If you fail to comply with the lease agreement, you could be penalized when it comes time to return the car to the lease company.
River Capital Advisors is a fee-only, SEC registered investment advisory firm that provides a range of financial services for its clients. RCA is a member of The National Association of Personal Financial Advisors and the Garrett Planning Network. We provide individuals options in how they want to work with RCA to help them in all areas of their financial life, as discussed in this blog posting. RCA is also affiliated with the Jacksonville CPA firm of Smoak, Davis & Nixon, LLP (SDN). The combination of RCA and SDN, along with being a fee-only investment advisor and a financial fiduciary to our clients makes RCA the exception and not the norm in the financial services industry.
Please contact us to have a conversation with one of advisors to learn how we can help you and your family in all areas of your financial life.